Growth stocks may be in line for a comeback as PE ranges narrow

Serious Money: On one of those financial TV channels the other day, somebody asserted that every stock in the world is now on the same price/earnings (PE) ratio. The point this commentator was trying to make is that we have been witnessing the most extraordinary compression of equity valuations to the point where many stocks trade on similar multiples.

Three questions naturally arise from this. First, is it true? Second, to the extent that it is true, why has it happened? Third, what are the implications?

Clearly, the assertion is not literally true: not every company is valued in exactly the same way. But there is a surprising amount of evidence to suggest that valuations have indeed become unusually similar.

Take PE ratios at the market level. According to Bloomberg data, the Dow Jones Euro Stoxx 50 trades on a multiple of 12.2 times earnings over the next 12 months.

The multiple for the French CAC 40 and the German Dax index is also 12.2 times next year's earnings. The corresponding multiple for the UK's FTSE 100 is 12.7. Spain's multiple is 13 while the Netherlands's is 11.4. The Swiss market is one of Europe's most highly rated and trades on 14.2 times.

As we can see, these are all very similar numbers.

Further afield, we find in the US that the S&P is trading on 16-times earnings.

Valuation compression, across markets at least, appears to be a European phenomenon (this does not rule out the possibility that US stocks have become compressed around a multiple of 16).

Once we dig down into the sector and stock level we find, not surprisingly, that valuation differences still exist. But we do find that the range of valuation possibilities has become remarkably narrow. While it is fatuous to say that all stocks are on the same PE, it turns out that there is plenty of evidence, just as is indicated by market PEs, suggesting a surprising degree of PE compression. Why has this happened?

It could be that markets, finally, are becoming more efficient. To the extent that valuation gaps in the past were anomalous - unjustified by underlying fundamentals such as profits and dividends - the activities of a more professional class of fund manager could be acting to eliminate those valuation gaps that should never have existed in the first place.

Narrow valuation ranges are, perhaps, more normal than appears at first sight. Those tried and trusted old strategies of selling high PE stocks, and vice versa, have finally led to stock prices becoming more aligned with reality.

The activities of hedge funds and private equity groups have probably been important in this regard. They have simply taken advantage of market inefficiencies - PEs that were either too high or too low - to make money.

On this line of reasoning, the easy money has now been made. Pricing anomalies can only be arbitraged away once. The low-hanging fruit has been picked - one reason why some people think that returns from investing in hedge funds and private equity will be lower in the future.

But there are also profound implications for traditional fund managers. Most importantly, the old value-versus-growth debate becomes redundant in a world where stocks are similarly valued.

In the old days, some fund managers styled themselves as either "growth" or "value" investors. Crudely, the former tended to believe that investment returns would be highest from companies that grow their earnings quickly - which often meant buying stocks with high PE ratios.

Value managers, by contrast, searched for undervalued companies, often defining them to be ones with low PE ratios. Since the bursting of the technology bubble in 2000, growth investing has performed poorly and has become somewhat discredited as a result.

While some of us may argue that the whole growth-versus-value debate is both artificial and sterile, it remains a serious topic of concern for many money managers. And growth may be just about to make a very unexpected comeback.

If valuations are really that similar, the raison d'etre for value-based fund management has just all but disappeared. By definition, in a world of narrow to non-existent valuation gaps, one of the few factors left to distinguish stocks is their growth history and outlook (there are other factors, such as quality - something that can embrace growth, but this is a technical digression that need not detain us here). The valuation discussion is irrelevant: simply buy stocks with better growth prospects.

If all or any of these arguments are valid, it will represent a remarkable turn of events. Value investors have been cleaning up for the past five years and many people had assumed that the debate over the relative merits of the two investment approaches had been settled.

Of course, the truth is rather more nuanced than the black-and-white picture presented above. There are still some valuation differences. And it is often easier said than done to identify, accurately, companies with superior growth prospects. Growth, for its own sake, can be a two-edged sword: it is no good if a firm invests for growth and achieves it at the expense of lower profitability.

The current vogue growth stock is Google, whose earnings are growing as revenues seemingly double every quarter. Growth rates like that, for as long as they continue, render discussion about the PE multiple, or any other valuation metric, largely irrelevant.

It might be thought that, in an increasingly competitive world, only very few companies have genuine growth prospects. The vast bulk of businesses are, in this model, going to find it harder and harder to grow their profits at faster than GDP-style rates.

The few companies that can do better than this are the ones that will deserve premium ratings as that rarest of beast, the genuine growth story.

The fund manager best placed to take advantage of this world might well end picking companies as diverse as BMW, Antofagasta, BP, Vodafone - and Google.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.